The decision on 15 December 2005 in the case of Jones v Garnett was a victory for the taxpayer and a blow for HM Revenue and Customs (HMRC).
The case concerned a husband and wife, Geoff and Diana Jones, and their company, Arctic Systems, which was set up in 1992. In common with family businesses' tax planning and on the advice of their accountants, one share was issued to Mrs Jones and one share to Mr Jones. The company was used to exploit the personal services of Mr Jones as an IT consultant. However, Mrs Jones did all the bookkeeping, liaised with the accountants and the bank, organised insurance, dealt with the contracts and dealt with other administrative tasks for around four or five hours an week on the company's business. Both Mr and Mrs Jones received a salary from the company, on which PAYE was accounted for. Mr and Mrs Jones received £8,400 and £3,600 per annum respectively.
In 1999/2000, dividends of £25,767.25 were paid to each of the shareholders. HMRC assessed that the dividend paid to Mrs Jones was income deemed to be the income of Mr Jones.
The settlements legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert his or her annual income to another person who is liable to tax at a lower rate. In the case of Mr and Mrs Jones, HMRC claimed that by allowing Mrs Jones to be an equal shareholder and not drawing most of the income as a salary, Mr Jones had entered into arrangements which amounted to a settlement.
The Court of Appeal found in favour of the Joneses and said that the subscription by Mrs Jones for her share was a normal commercial transaction, so no settlement arose.
The court also noted it was important that there was no contract or obligation for Mr Jones to provide his services to the company at an undervalue.
As a result of the previous High Court decision, many taxpayers in a similar situation may have been advised to prepare and submit their self-assessment tax returns for the year ended 5 April 2005 based on the decision which has now been overturned by the Court of Appeal. This could mean that one spouse is paying tax on the other spouse's income.
If this is the case, you should 'repair' the return based on the decision passed down on 15 December 2005. For the 2004/05 tax return you will have until 31 January 2007 to do this. However, as payments on account are based on the previous year, you may be making higher payments on account, so you should therefore make a claim to reduce these if you did not repair the return before 31 January 2006. Speak to your tax office about how to do this.
For taxpayers who self-assessed on the basis that the case would be overturned, no action is needed on their returns.
Paula Tallon is director and head of direct tax at Chiltern plc